[Joint House and Senate Hearing, 112 Congress]
[From the U.S. Government Publishing Office]
S. Hrg. 112-191
WHAT IS THE REAL DEBT LIMIT?
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HEARING
before the
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
__________
SEPTEMBER 20, 2011
__________
Printed for the use of the Joint Economic Committee
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JOINT ECONOMIC COMMITTEE
[Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]
SENATE HOUSE OF REPRESENTATIVES
Robert P. Casey, Jr., Pennsylvania, Kevin Brady, Texas, Vice Chairman
Chairman Michael C. Burgess, M.D., Texas
Jeff Bingaman, New Mexico John Campbell, California
Amy Klobuchar, Minnesota Sean P. Duffy, Wisconsin
Jim Webb, Virginia Justin Amash, Michigan
Mark R. Warner, Virginia Mick Mulvaney, South Carolina
Bernard Sanders, Vermont Maurice D. Hinchey, New York
Jim DeMint, South Carolina Carolyn B. Maloney, New York
Daniel Coats, Indiana Loretta Sanchez, California
Mike Lee, Utah Elijah E. Cummings, Maryland
Pat Toomey, Pennsylvania
William E. Hansen, Executive Director
Robert P. O'Quinn, Republican Staff Director
C O N T E N T S
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Opening Statements of Members
Hon. Kevin Brady, Vice Chairman, a U.S. Senator from Texas....... 1
Hon. Jim DeMint, a U.S. Senator from South Carolina.............. 1
Hon. Elijah E. Cummings, a U.S. Representative from Maryland..... 3
Witnesses
Dr. Allan H. Meltzer, The Allan H. Meltzer University Professor
of Political Economy, Carnegie Mellon University, Pittsburgh,
PA............................................................. 5
Mr. Chris Edwards, Director of Tax Policy Studies, Cato
Institute, Washington, DC...................................... 7
Dr. Laurence Ball, Professor of Economics, Johns Hopkins
University, Baltimore, MD...................................... 9
Submissions for the Record
Prepared statement of Representative Kevin Brady................. 28
Chart titled ``Total U.S. Government Spending = 41% of GDP
(2011)''................................................... 30
Chart titled ``Rise in Fed's Treasury Holdings Accounts for
More Than One-Third the Rise in U.S. Debts Since March
2009''..................................................... 31
Chart titled ``What is the Tipping Point?''.................. 32
Chart titled ``Gross Government Debt as a Percent of GDP''... 33
Chart titled ``Federal Reserve Balance Sheet = $2.9
Trillion''................................................. 34
Chart titled ``Long Term Budget Outlook; Debt to GDP Ratio''. 35
Prepared statement of Dr. Allan H. Meltzer....................... 36
Prepared statement of Mr. Chris Edwards.......................... 39
Prepared statement of Dr. Laurence Ball.......................... 48
WHAT IS THE REAL DEBT LIMIT?
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TUESDAY, SEPTEMBER 20, 2011
Congress of the United States,
Joint Economic Committee,
Washington, DC.
The committee met, pursuant to call, at 10:04 a.m., Room
210, Cannon House Office Building, the Honorable Kevin Brady,
Vice Chairman, presiding.
Senators present: DeMint.
Representatives present: Brady, Burgess, Campbell,
Mulvaney, and Cummings.
Staff present: Connie Foster, Robert O'Quinn, Michael
Connolly, Rachel Greszler, Gail Cohen, Will Hansen, Colleen
Healy, and Jesse Hervitz.
OPENING STATEMENT OF HON. KEVIN BRADY, VICE CHAIRMAN, A U.S.
REPRESENTATIVE FROM TEXAS
Vice Chairman Brady. Good morning, everyone. Welcome to the
Joint Economic Committee hearing. The topic is, ``What is the
Real Debt Limit?'' We so appreciate the panelists we have here
today.
And I want to commend Senator DeMint, who leads Senate
Republicans on the Joint Economic Committee, for spearheading
this hearing on this very important and timely topic. And I
would yield to Senator DeMint for the opening statement.
OPENING STATEMENT OF HON. JIM DEMINT, A U.S. SENATOR FROM SOUTH
CAROLINA
Senator DeMint. Thank you, Mr. Chairman. And I appreciate
all of your work and your staff's work to put this together.
And I want to thank all of our panelists for taking their
time to be here.
A couple of months ago in Washington, everyone was in a
panic of what might happen if we couldn't borrow any more
money. And the President mentioned we might not be able to pay
Social Security. We talked about reneging on payments to
contractors. We talked about a pretty dire situation if the
United States could not borrow any more money.
But that debt limit was an arbitrary debt limit set by
Congress, one that we could change by a simple debt-limit deal.
My concern and I think that a number of Americans is, where is
the real debt limit? When do we hit the wall where no one will
lend us any more money and perhaps the Feds can't even print
enough money? At what point is there not enough credit in the
world to continue to finance not only the United States but all
the debtor nations?
You know, under CBO's alternative budget forecast, their
model essentially stops working in the early 2040s because of
excessive U.S. debt. I just want to look at a couple of charts
here of where we see the debt going relative to the GDP. There
is no way we are going to get that far. My concern is, can we
borrow another 2\1/2\ trillion? The Federal Reserve is
apparently buying a lot of our debt already. Is there still a
market for the kind of debt that the United States needs to
sell?
Despite the commitment to reduce our deficit--and, again,
``deficit'' is a Washington term, the year-to-year shortfall--
we have said we would reduce that year-to-year shortfall $2.1
trillion over the next 10 years, giving the impression to
Americans that we are actually lowering the debt, when, as I am
sure all of our panelists know, we are going to continue to
increase the debt. It may be $8 trillion, $10 trillion; we are
not sure. But, again, if we look at our charts, I am not sure
we can borrow that much money.
But if we look here, at what we are trying to discover
today, or determine, or guess at: Where is the tipping point
for America beyond which the interest rates will rise sharply,
economic growth will decline dramatically? As we look at the
potential tipping point for Greece and Ireland and Portugal and
U.S. as a percent of GDP, we see the United States is right
there where these other nations are. Is the only thing that
makes us different that we can print money and that we are the
world's reserve currency? These other countries can't print
their own. But hopefully our panelists will help us sort this
out.
And what does the United States look like once we reach
that tipping point, when we hit a very real debt limit? How
high will interest rates go? What will be the borrowing cost if
we can, in fact, borrow the money? Will the Fed just print
money? These are things we are trying to anticipate.
The Fed is clearly engaged in unprecedented action,
including the purchase of trillions of dollars of U.S.
Treasuries and mortgage-backed securities. You know, since the
financial crisis in 2008, the Fed's balance sheet has tripled
to $2.9 trillion. We can see here what the Federal Reserve has
done, with very little notice by Congress, which effectively
means we are printing money and buying debt.
So how could the Fed's policies affect the tipping point?
What can we expect? There are a lot of questions. And,
certainly, we need to know, how long can the Federal Reserve
monetize our debt before the world begins to lose confidence in
our currency?
So my challenge to the panelists today is that, all
politics aside, all partnership aside, our country is drowning
in debt. The plan by this government is to continue borrowing
money for the foreseeable future. Any talk of balancing the
budget is considered extreme. What does that mean for our
country? How much time do we have, and what is going to happen
when we can no longer borrow money?
Thank you, Mr. Chairman.
Vice Chairman Brady. Thank you, Senator.
The chair recognizes Representative Cummings for an opening
statement.
OPENING STATEMENT OF HON. ELIJAH E. CUMMINGS, A U.S.
REPRESENTATIVE FROM MARYLAND
Representative Cummings. Thank you very much, Mr. Chairman.
I want to thank you, Vice Chairman Brady, for calling
today's hearing to examine the effects of the national debt on
our broader economy.
I welcome our witnesses and extend, particularly, a warm
welcome to Dr. Laurence Ball, professor of economics at Johns
Hopkins University. And Johns Hopkins, of course, is located in
Baltimore and smack-dab in the middle of my district.
Last week, the Director of the Congressional Budget Office
testified before the new Joint Select Committee on Deficit
Reduction. He reported that if we proceed under current law--
for example, allowing the Bush tax cuts to expire at the end of
this year--by 2021 debt held by the public will equal 61
percent of GDP, well above the annual average of 37 percent
recorded between 1971 and 2010. Under the CBO's so-called
``alternative baseline,'' in which the Bush tax cuts and the
AMT patch are extended and other current policies continue,
debt held by the public is expected to balloon to nearly 190
percent of GDP by 2035.
The Director testified that, notwithstanding the latest
long-term projections under the so-called Budget Control Act,
interest payments on the debt and lost confidence in our
ability to manage our budget would create a clearly
unsustainable scenario. However, the CBO Director also told the
committee that there is no inherent contradiction between using
fiscal policy to support the economy today and imposing fiscal
restraints several years from now. He instructed, if we want to
achieve both a short-term economic boost and longer-term fiscal
sustainability, a combination of policies would be required:
changes in taxes and spending that would widen the deficit now
and reduce it later in the coming decade.
Thus, the CBO Director confirms what countless economists
have been warning Congress about. Draconian spending cuts will
not generate the economic growth we need now, right now, to put
Americans back to work and enable them to compete and succeed.
Moreover, such harmful cuts are unnecessary to rein in the debt
and will only serve to slow our already tepid growth,
ultimately reducing revenues coming in through taxes.
In fact, one of the major causes of our current budget
deficits, and, thus, a major cause of the growing debt, is our
continued slow economic growth. The recession that started in
2007 is responsible for more than $400 billion of our annual
deficits between 2009 and 2011, according to the Center for
Budget Policies and Priorities and the CBO. Therefore, one of
the most effective steps we could take to tackle the debt right
now is to start growing the economy again, which is also what
the American people desperately need and desperately want.
According to Laura Tyson, chairwoman of the Council of
Economic Advisers and the National Economic Council in the
Clinton Administration, which presided over one of the most
sustained periods of economic growth and job creation in our
Nation's history, investments in infrastructure, job training,
and research and development, which would address the immediate
jobs gap and foster future growth, would help reduce the
deficit. An extra percentage point of growth over the next 5
years would do more to reduce the deficit during that period
than any of the spending cuts currently under discussion. And
over the next decade, an extra percentage point of growth would
add about $2.5 trillion in revenue.
While this hearing is aimed at examining the impact of the
Federal debt on our economy, I would submit that, at present,
the debt is a nominal factor in our current economic outlook.
Rather, slowed hiring, low consumer confidence and demand,
skills mismatches between workers and jobs, reduced public
investment, and the continuing foreclosure crisis are driving
our economic conditions and our rising debt, rather than the
other way around.
Finally, until we recognize this reality and move to tackle
these challenges, an exclusive focus on the debt crisis will
essentially consign our Nation to chasing our economic tail--a
wholly unnecessary and unproductive exercise. However, I
anxiously look forward to hearing from our witnesses. I thank
you all for being here today.
And, with that, Mr. Chairman, I yield back.
Vice Chairman Brady. Thank you.
Two housekeeping notices. One, the clocks are not working,
so we will be keeping the time manually. And we will make
notice of that as we come up to the 5-minute time limit for
both testimony and questions.
Also, I have an opening statement I would like unanimous
consent to insert into the record, without objection.
[The prepared statement of Representative Kevin Brady
appears in the Submissions for the Record on page 28.]
[Chart titled ``Total U.S. Government Spending = 41% of GDP
(2011)'' appears in the Submissions for the Record on page 30.]
[Chart titled ``Rise in Fed's Treasury Holdings Accounts
for More Than One-Third the Rise in U.S. Debts Since March
2009'' appears in the Submissions for the Record on page 31.]
[Chart titled ``What is the Tipping Point?'' appears in the
Submissions for the Record on page 32.]
[Chart titled ``Gross Government Debt as a Percent of GDP''
appears in the Submissions for the Record on page 33.]
[Chart titled ``Federal Reserve Balance Sheet = $2.9
Trillion'' appears in the Submissions for the Record on page
34.]
[Chart titled ``Long Term Budget Outlook; Debt to GDP
Ratio'' appears in the Submissions for the Record on page 35.]
Vice Chairman Brady. And the chair yields to Senator DeMint
for introduction of the panelists.
Senator DeMint. Okay. Thank you, Mr. Vice Chairman. It is
my privilege to introduce our three distinguished witnesses to
provide testimony on this matter of such enormous importance to
the American people and to the future health of our economy.
Our first witness, Dr. Allan Meltzer, is currently a
professor of political economy and public policy at the
Carnegie Mellon University's Tepper School of Business in
Pittsburgh, Pennsylvania. He has previously served as a member
of the President's Economic Policy Advisory Board, an active
member of the President's Council of Economic Advisers, and a
consultant to the U.S. Treasury Department and the Board of
Governors of the Federal Reserve System.
In 1999 and 2000, he served as the chairman of the
International Finance Institution Advisory Commission, which
was formed by Congress to review the role of the International
Monetary Fund, the World Bank, and other world financial
institutions. He is the author of numerous books on economic
theory and policy, including a multivolume ``History of the
Federal Reserve.''
Dr. Meltzer received his B.A. from Duke University and an
M.A. and Ph.D. in economics from the University of California
at Los Angeles.
Next, we will be hearing from Mr. Chris Edwards, who is
currently the director of tax policy studies at the Cato
Institute and editor of Cato's Web site,
DownsizingGovernment.org.
Before he began his work at Cato, he was senior economist
for the Joint Economic Committee, as well as an economist for
the Tax Foundation from 1992 to 1994. He is also the author of
``Downsizing the Federal Government'' and co-author of ``Global
Tax Revolution.''
Mr. Edwards holds a B.A. and an M.A. in economics.
Our final witness is Dr. Laurence Ball. Dr. Ball is a
professor of economics at Johns Hopkins University. He
previously taught at Princeton University and New York
University. Dr. Ball has done extensive research and writing on
a variety of economic topics, including the foundations of
Keynesian economic models. He has done in-depth studies of
inflation and monetary policy in both the United States and in
high-inflation countries, with a specific focus on how best to
reduce inflation and the economic cost of inflation.
Dr. Ball is currently a research associate at the National
Bureau of Economic Research. He was previously a lecturer at
the IMF Institute, a member of the Federal Reserve Board's
Academy Advisory Panel, and a consultant on the International
Monetary Fund's World Economic Outlook.
Dr. Ball holds a B.A. in economics from Amherst College and
a Ph.D. in economics from Massachusetts Institute of
Technology.
It is an honor to have all of you here today and to benefit
from your expertise on this subject.
Vice Chairman Brady. The chair recognizes Dr. Meltzer.
STATEMENT OF DR. ALLAN H. MELTZER, THE ALLAN H. MELTZER
UNIVERSITY PROFESSOR OF POLITICAL ECONOMY, CARNEGIE MELLON
UNIVERSITY, PITTSBURGH, PA
Dr. Meltzer. Thank you, Mr. Chairman. Thank you, Vice
Chairman Brady, Senator DeMint, members of the committee. It is
a pleasure to appear before the Joint Economic Committee.
My association with this committee goes back to the days of
Senator Paul Douglas. It was Senator Douglas who pushed and
prodded the Federal Reserve to stop holding interest rates
fixed and to permit monetary policy to do much more to prevent
inflation. His views eventually prevailed. That should remind
the Members of their responsibility.
Today I will answer the questions that the hearing seeks to
answer. They are good questions that show the rising concern
for the consequences of recent Federal Reserve actions. I will
introduce my answers with my explanations of why Federal
Reserve policy is misguided and mistaken, inflationary and
inappropriate. There are several reasons; I will give three.
First, in writing the three volumes of ``A History of the
Federal Reserve,'' I read more minutes and transcripts than any
person can endure. With very rare exceptions, notably in the
years when Paul Volcker led the disinflation policy, one looks
in vain for a statement of the medium-term consequences of the
actions taken at the meeting. True, the staff and others
provide forecasts of the future, but the FOMC never tries to
reach agreement on the consequences of its actions for the
public. It publishes forecasts, but there is no clear relation
between the forecasts and the actions.
Second, concerns at FOMC meetings are mainly about the near
term. The Federal Reserve has little influence over what will
happen in the near term but much greater influence on the
medium term. The present is characteristic. The Fed Chairman
and some of the members seem determined to, quote, ``do
something,'' end quote, more about the excessive waste and the
harm of high unemployment. They neglect the fact that there is
no shortage of money and liquidity and that they have pushed
and prodded market interest rates to the lowest levels ever
achieved anywhere.
The United States does not have a problem of too little
liquidity. There is not much that the Federal Reserve can do by
adding reserves or lowering interest rates. The last time they
tried it, $600 billion was added; $500 billion ended up in
excess reserves. Don't the Chairman and several members
understand that there are limits to what the Federal Reserve
can do?
Banks hold more than $1.5 trillion of idle reserves. Money
growth, M2, for the past 6 months is rising at an almost 15
percent annual rate. I attached a chart to my paper, or asked
the staff to do that. Here is the chart, and it shows the
enormous increase recently in the rate of increase in M2
growth. Inflation, as a result, has begun to rise. Prices are
rising, and the U.S. dollar continues to sink.
The most useful action that the Federal Reserve could take
would be announcement of an enforceable inflation target that
would give confidence that we will not inflate.
Third, in 1977, Congress gave the Federal Reserve a dual
mandate, interpreted as low unemployment and low inflation. It
pursues these goals in an inefficient way by pursuing
unemployment until inflation rises, shifting to inflation
control until unemployment rises, and back and forth. That way,
it achieves neither.
The ``Great Inflation'' of the 1970s is an extreme example.
Both unemployment and inflation rose. The current Fed repeats
that pattern. In contrast, policy from 1985 to 2003 more or
less followed a rule that included both goals. That gave the
public one of the very few years of low inflation and stable
growth in the Fed's 100-year history.
In Article I, Section 8, our Constitution gives Congress
ultimate control of money. It should legislate an enforceable
inflation target. I will amplify ``enforceable'' if you wish.
Now, the three questions that the hearing has asked me to
address.
First, given the fiscal policy of the industrial nations,
will government debt crowd out private investment? My answer is
``yes.'' Today's deficits and debt raise concerns about future
tax rates. The prospect of higher future tax rates raises the
rate of return that business investors expect to earn on new
investment. And uncertainty about future tax rates and the
persistent increase in regulation of health, labor, and energy,
and finance has deterred investment and slowed recovery. Faced
with heightened current uncertainty, many investors hold cash
and wait. Cash is their friend.
Government budget and regulatory policies deter and crowd
out investment. One of the most effective things that the
Congress could do was to pass a moratorium on new regulation
for the next 5 years, excepting national security.
Vice Chairman Brady. Dr. Meltzer, the 5-minute time limit
has expired. Would you conclude your testimony? And we will
have a chance during questioning to pursue further.
Dr. Meltzer. Yes.
Let me say only this about the tipping point. Why wait for
a tipping point and a crisis?
We know that the debt is now a hundred percent,
approximately a hundred percent, of GDP. That doesn't include
the unfunded liabilities. It doesn't include Fannie Mae and
Freddie Mac. It doesn't include a number of other things.
So there isn't a point that we can mark down and say, after
this crisis occurs. We don't know when crises will occur. And
the experience of Italy and Greece, especially, recently tell
us that the market suddenly changes its mind without warning
and without prior notification. So we shouldn't wait for that
to happen. We should begin.
We have ample warning that we are on an unsustainable path.
That unsustainable path--to respond to Congressman Cummings, is
to say that we need to announce a plan that will reduce the
deficit in a credible way, not beginning by taking everything
off the table today, but announcing a plan which will put us on
the path that we have to be on if we are going to restore the
long-term growth rate of the United States with low inflation.
[The prepared statement of Dr. Allan H. Meltzer appears in
the Submissions for the Record on page 36.]
Vice Chairman Brady. Thank you, Doctor.
And I should note that all of the testimony of the three
witnesses will be submitted in full in the testimony.
The chair recognizes Mr. Edwards, 5 minutes.
STATEMENT OF MR. CHRIS EDWARDS, DIRECTOR OF TAX POLICY STUDIES,
CATO INSTITUTE, WASHINGTON, DC
Mr. Edwards. Thank you very much, Vice Chairman Brady and
members of the committee.
Federal spending, as you know, has soared over the last
decade. And looking ahead, the CBO projects that Federal
spending will rise from 24 percent this year to 34 percent of
the economy by 2035 unless we make some serious reforms. And as
your chart showed, the Federal debt, according to the CBO, will
explode to almost 200 percent of GDP by 2035 unless we make
reforms.
Now, some people and economists think it is okay if America
raises taxes and spending in coming years because they think we
have a uniquely small government in this country, but that is
really no longer the case. If you look at OECD data, total
Federal/State/local spending in the United States now is 41
percent of GDP. That is only 4 percent less than the OECD
average spending now of 45 percent of GDP. We used to have a
10-percentage-point-of-GDP advantage in terms of a smaller
government, so that has shrunk now from 10 down to 4 percent.
So, sadly, we are becoming just another sort of an average,
bloated welfare state, which I think is really going to damage
our economy.
And if you look at debt, I think one of your charts showed
United States Federal debt, gross debt, at 101 percent of GDP
now, higher than the OECD average of 78 percent of GDP. And if
you look at growth and debt over the last 4 years, our debt has
grown the sixth fastest out of the 31 OECD countries. So, you
know, there are a lot of debt crises going on in Europe, but we
are certainly getting up to that level of fiscal
irresponsibility.
Without reforms, government spending may represent about
half of GDP by 2035, which, in my view, would create a dismal
future for young Americans, with fewer opportunities. I think,
historically, our high standard of living has been based on a
relatively smaller government, and it would be really sad to
lose that.
In my view, there are three basic harms of all this--that
all this deficit spending creates.
The first basic harm is that additional spending, in my
view, sucks resources out of the more productive private-sector
economy, puts it in the less productive government sector of
the economy. Again, if the government in America is already
spending 4 out of every 10 dollars, it seems to me that
marginal spending in the government sector is going to have a
lower negative return.
In a 2008 book, Texas A&M public finance professor Edgar
Browning, he went through the whole Federal budget, looked at
Federal spending, and he figures that the extent of Federal
spending we do these days in the United States has lowered
overall average incomes by about 25 percent. So we are above
the tipping point or optimal level for the size of our
government in terms of economic growth.
The second basic harm that all this deficit spending is
doing, of course, is creating deficits, which are essentially
deferred taxes that will pinch the economy down the road.
Economists look to the distortions caused by the Tax Code as
damaging the economy. This is called deadweight losses. When
you raise taxes, you create more distortions in the economy,
which reduces GDP.
And the third harm of all the deficit spending is the high
debt itself, as we are seeing, is creating financial
instability and economic uncertainty. And we can certainly see
this in Europe. A number of economists now have written about
how 90 percent seems to be sort of a tipping point for debt as
a share of the economy, and, above that, economic growth starts
to slow.
And here is what I think a lot of people are missing in
this debate. When you look at those long-term CBO projections--
I think you had some on your charts--that show the rising debt
and rising spending, it looks bad enough, but it is actually
worse than that, because in CBO's basic alternative fiscal
scenario, their basic benchmark projection, they don't take
into account the fact that the rising debt and spending
suppresses GDP.
In a special analysis, the CBO looks every year at how that
rising debt suppresses GDP, and it is pretty scary. It could
well be, according to the CBO under some of its scenarios, that
real U.S. incomes rise for the next decade or so but then they
stagnate and then they start falling. This would be sort of a
reversal of American history if American incomes actually
started falling over the long term.
Last year, CBO compared Paul Ryan's roadmap, which sort of
keeps spending at today's level, versus the sort of do-nothing
alternative fiscal scenario. And they found, by the 2050s, U.S.
average incomes would be 70 percent higher under the Paul Ryan
roadmap plan than under the alternative fiscal scenario because
of the buildup of debt.
Some fear, of course, that spending cuts in the short term
would hurt the economy. I would only point out that, you know,
we have had $5 trillion of deficit spending since 2008, the
most enormous sort of Keynesian stimulus you can imagine, and
yet we have the slowest recovery since World War II. So I don't
think spending helps.
And I think if you look around the world at real-world
examples--your staff has put out a useful study looking at
Canada and Sweden and other countries that have cut their
spending. Canada, for example, dramatically cut their spending
in the mid-1990s, and it didn't depress the economy. Quite the
reverse: The Canadian economy boomed for 15 years even as
spending was cut pretty dramatically.
So, you know, I think Congress should turn its attention to
major spending cuts as soon as we can. And, you know, at Cato
we have all kinds of ideas for cutting every Federal Government
department. I don't look at spending cuts as sort of painful
medicine that we should fear; I think it would be a positive
boom for economic growth.
Thank you very much.
[The prepared statement of Mr. Chris Edwards appears in the
Submissions for the Record on page 39.]
Vice Chairman Brady. Thank you, Mr. Edwards.
The chair recognizes Dr. Ball for 5 minutes.
STATEMENT OF DR. LAURENCE BALL, PROFESSOR OF ECONOMICS, JOHNS
HOPKINS UNIVERSITY, BALTIMORE, MD
Dr. Ball. Vice Chairman Brady and members of the committee,
thank you for this opportunity to share my views on U.S. fiscal
policy.
Other witnesses have emphasized the dangers of rising
government debt, and I agree that reforms are needed to put
debt on a sustainable path. I will focus, however, on a
different side of the issue: the costs of controlling debt by
cutting government budget deficits. And here, this will be
largely elaborating on a point raised by Congressman Cummings.
I will argue that cutting deficits reduces economic growth and
raises unemployment in the short and medium run. These costs
are especially large if deficit reduction is too hasty and
occurs during an economic slump.
Now, opinions about the short-run effects of fiscal policy
vary widely, as we all know. Most economics textbooks teach
that a fiscal tightening slows the economy by reducing the
demand for goods and services. Some economists disagree with
this view, suggesting that tightening is expansionary because
it boosts confidence in the economy.
Both sides of this debate have reasonable arguments. If we
want to know who is right, we have to look at the evidence.
And, in my view, the evidence is clear: Cuts in budget deficits
have adverse effects that last for 5 years or more. If Congress
cuts spending or raises taxes today, its actions will slow
economic growth and raise unemployment until at least 2016.
Now, this conclusion is supported by numerous studies--
admittedly, not all studies. I will focus on research performed
over the past 2 years at the International Monetary Fund, work
that many economists view as the best available evidence on the
effects of deficit reduction. My written testimony describes
this research in detail. In these remarks, I will summarize it
briefly.
IMF researchers reviewed the history of 15 countries over
the period from 1980 through 2009. They identify a total of 173
years in which governments reduced budget deficits through
spending cuts, tax increases, or a combination of the two. The
research finds that, on average, a deficit reduction of 1
percent of GDP raises the unemployment rate by four-tenths of
percentage point after 2 years, and unemployment is still two-
tenths of a point higher after 5 years. An important detail is
that higher unemployment results mostly from higher long-term
unemployment, meaning workers without jobs for 26 weeks or
more.
Making matters worse, these average effects of deficit
reduction are likely to understate the effects in today's U.S.
economy. In a typical episode studied by the IMF, a country's
central bank responds to fiscal tightening by reducing short-
term interest rates, and this monetary easing dampens the rise
in unemployment. Currently, the Federal Reserve cannot reduce
rates because they are already near their lower bound of zero.
In this situation, the evidence suggests that the costs of
deficit reduction are about twice their normal size.
To better understand these findings, let's consider one
hypothetical fiscal policy: a deficit reduction of 3 percent of
GDP. I picked this number because the Congressional Budget
Office forecasts deficits of about 3 percent of GDP from 2014
through 2020. With a 3 percent cut, deficits would fall to
roughly zero.
How would this policy affect unemployment? The evidence
says a deficit cut of 1 percent of GDP raises unemployment by
about 0.8 percentage points when interest rates are near zero.
This means the 3 percent cut in my example would raise
unemployment by 2.4 percentage points. With a U.S. labor force
of 150 million people, an additional 3.6 million Americans and
their families would suffer the consequences of a lost job.
Let me mention another important finding of the IMF study.
Recent political debates have focused on the choice between
deficit reduction through cuts in government spending and
through tax increases. This choice, of course, matters a lot to
the beneficiaries of government spending and to people who pay
taxes. In one way, however, this choice is not important. The
IMF performed separate analyses of spending cuts and tax
increases and finds that the adverse short-run effects on
economic growth and unemployment are similar in the two cases
if interest rates are near zero.
Now, the question, of course, is, can any policy rein in
government debt without slowing the economy? And a possible
answer is a fiscal consolidation in which spending cuts and tax
increases are back-loaded in time. And, again, I think this is
related to Congressman Cummings' idea of something which is
more stimulative in the short run but gets debt under control
in the long run.
Under such a policy, the government would commit to lower
deficits in the future without sharply cutting the current
deficit. Just as one example of how this might be done, one
could imagine cost-saving changes in entitlement programs, such
as a higher retirement age, that could be phased in over time.
With any luck, major spending cuts would occur only after
the economy has recovered from its current slump. Deficit
reduction will be less painful then, in part because interest
rates will be above zero and the Federal Reserve could ease
monetary policy.
And let me thank you again for your attention.
[The prepared statement of Dr. Laurence Ball appears in the
Submissions for the Record on page 48.]
Vice Chairman Brady. Well, thank you all for your testimony
today. And we will begin a round of questioning.
The question today, posited by Senator DeMint, is, what is
the real debt limit for America? And the answer seems to be, it
is dangerously near and not in our control. As Dr. Meltzer
said, market perceptions and actions change quickly, and
countries that act prudently ahead of the crisis are in a
better position.
And my question to Mr. Edwards and Dr. Meltzer is, do you
think there are some lawmakers in Washington in denial about
the seriousness of our debt crisis? Because, temporarily, the
costs of borrowing for this country are low, are being masked
by outside--well, both inside and outside, the Fed's
quantitative easing, lowering of interest rates, European
crises which create a flight to safety, so our borrowing costs
are temporarily lower.
Do you think that, once the true costs of America borrowing
are revealed, that there could be a more serious action by some
in Washington to get this debt crisis under control? Dr.
Meltzer? Mr. Edwards?
Dr. Meltzer. I believe that steps that have been taken are
preliminary steps--that is, to get $1.5 trillion or $1.2
trillion in reductions is just the beginning.
What we need to do is to give people confidence that their
future is going to be bright. We don't do that by throwing a
few dollars at them. We do that by giving them care that we are
on a stable path, that we are going to go back to the future
the way we knew the past.
And that means that when, unlike Mr. Ball, models like the
IMF model leave out is the fact that if you move resources from
low-productivity goods--you know, it may be very desirable for
people to receive transfers from the government. I don't
dispute that. But those have very low productivity use. If we
transfer resources to higher-productivity use, we raise the
future and their optimism. If we cut the deficit, we convince
people that their tax rates are not going to be higher in the
future.
The IMF model doesn't allow for that. It doesn't take into
account the productivity change, and it doesn't take into
account the beneficial effects of expected lower tax rates.
Those are important conditions.
Let me close by comment by saying two things. If we look at
the history of the postwar period, we find that there were
three fiscal changes that really did enormous good. One was the
Kennedy-Johnson tax cuts. Arthur Okun, who was the Chairman of
the Council of Economic Advisers, said the most effective part
of those tax cuts were the business tax cuts. They got the
biggest bang for the buck.
The second big fiscal change that worked well were the
Reagan tax cuts of the early 1980s and again in 1986. And the
third policy that gave people confidence were the Clinton tax
increases, which assured people that their future tax rates
were not going to go up, that they had seen what they were
going to have to pay and there wouldn't be any more.
That is important. Give people confidence. That is what the
public desperately needs at the moment, confidence that the
policies that the government puts out are going to be
sustainable and productive.
Vice Chairman Brady. Thank you, Doctor.
Mr. Edwards.
Mr. Edwards. Yeah, I think your question goes to the right
point, that because the United States is special, because we
are a haven for international capital in a dangerous world,
American policymakers have been able to get away with running
giant deficits for far too long. I think if we were a smaller
country like Australia, the crisis from our debt would have
already happened.
I noticed in a story yesterday on Bloomberg, Italy has just
been downgraded. And one of the things that I think it was S&P
noted is that they have been downgraded partly because they
have a dysfunctional political system. And that seems to be
sort of what is going on in the United States.
Canada, again, to go back to the 1990s, hit the wall with
their debt at 80 percent of GDP. Ours is up to 100 percent of
GDP. So we have been skating along for so long, I think, partly
because we are in this special situation. And Japan shows that
you can run along sort of as a zombie economy for a decade or
two with debt at 200 percent of GDP.
So, you know, the real damage, though, I think, you know,
is ultimately the spending. We have to get the spending under
control. And that has been the key to success in places like
Canada and Sweden that have cut their deficits.
Vice Chairman Brady. Thank you. The point, I think, from
both being: The key is to restore consumer and business
confidence by getting our financial house in order with a
credible way to shrink the size of government to restore that
balance.
Mr. Cummings.
Representative Cummings. Thank you very much, Mr. Chairman.
Just adding on to what was just said by Mr. Brady, Dr.
Meltzer, did I understand you correctly to say--when you talked
about when President Clinton raised the taxes, you said--you
didn't see that as a negative thing. You saw it, in a way, I
think--now, correct me if I am wrong--as something that created
a level of certainty. And you are saying that the certainty is
more important than some other factors? Is that accurate?
Dr. Meltzer. Well, let me say, he also had the benefit of
the end of the cold war.
Representative Cummings. We really want to hear this. Is
your microphone on?
Dr. Meltzer. Sorry.
Representative Cummings. Yes, don't go silent on me.
Dr. Meltzer. He really had the benefit of the end of the
cold war. So he was able to cut spending. And he was able to
cut--he had Mr. Rubin there. Mr. Rubin, being a finance person
from Wall Street, told him, don't run deficits. And he didn't
run deficits, and he gave people confidence.
Now, does that mean that a tax increase now would do what a
tax increase then did? I don't believe so.
Representative Cummings. Okay.
Well, let's pick up on that, Dr. Ball. In 1999, postwar,
middle-class incomes peaked. And, by the way, during that
Clinton era, we produced some 22 million jobs. Since 2000 they
have steadily declined, notably notwithstanding the
implementation of historically low tax rates due to the passage
of the 2001 and 2003 Bush tax cuts. This reversal of growth has
led some economists to describe the time period between 2000
through 2010 as ``the lost decade'' for America's middle class.
Therefore, I find particularly troubling your findings that
the government-imposed austerity measures during economic
downturns have lasting negative impacts on economic and
employment levels and that the bulk of these negative effects
falls on middle-class and working people. Specifically, I am
concerned that, if the Select Committee on Deficit Reduction
achieves the required $1.2 trillion in savings only through
spending cuts, rather than through a balance of revenue and
cuts, this could result in a lost lifetime for millions of
Americans--for example, those who are 5 or 10 years away from
retirement.
Dr. Ball, if throughout the last decade working Americans
have watched their incomes stagnate or spiral downward and 25
million more Americans are unemployed or underemployed, are you
concerned about the detrimental impact that the $1.2 trillion
in cuts could have on America's workers and middle class?
Particularly in the context of the recent report that in
America we have now 46.2 million people living under the
poverty level, meaning $22,000 for a family of four?
Dr. Ball. Absolutely, I am very concerned about that. There
has been this stagnation of middle-class living standards that
has a variety of causes. But there is no question that a harsh
fiscal contraction right now would exacerbate that.
One thing I didn't have time to mention in my testimony was
another research finding, is that if you look at how total
income of the economy goes down when there is a cut in
government spending, it is disproportionately labor income or
wages as opposed to capital income. So there is every reason to
think that there would be a shift in the income distribution
away from workers, as well as a fall in total income.
And, as far as unemployment I don't think anybody really
needs a lecture on how terrible a problem unemployment is. And
there is a lot of research, but, again, it is also pretty
obvious that losing your job is especially difficult,
especially terrible during an economic downturn because then it
takes a long time to find a new job. We have almost half the
unemployed who are unemployed for 6 months or more. And I could
go in to some of the social science research about the damage
that does to families, health, divorce, children's performance
in schools, but I am sure all of you understand that.
Representative Cummings. Let me ask you this. You know, we
constantly hear, get rid of this regulation, get rid of that
regulation. You know, I wonder, when we get rid of all these
regulations, does that guarantee that jobs are going to be
added? In other words, you make it easier for the employer--you
take away safety measures, in many instances, from the public--
easier to make more money, but is that a guarantee that we will
then see jobs expand?
Dr. Ball. No, absolutely not. I mean, again, on any given
regulation, there are a lot of pros and cons about the costs
and benefits, but as a way of dealing with the current slump
and 9 percent unemployment, that is really, honestly, a non-
factor, because what we have is a classic shortfall of demand.
Normally when that happens, historically, the Federal
Reserve has dealt with that by cutting interest rates and, if
the economy doesn't recover, cutting interest rates some more.
What is uniquely problematic about the current situation is
that interest rates have hit zero, so the Fed has run out of
ammunition, at least its usual kind of ammunition. And we need
to somehow be creative and think about some other way to get
firm spending on investment and to get consumers spending.
Representative Cummings. Thank you, Mr. Chairman.
Dr. Meltzer. Congressman Cummings, may I add to that? May I
add to that?
Vice Chairman Brady. Briefly, Dr. Meltzer, yes.
Dr. Meltzer. Yes, briefly.
Cutting regulation and giving people assurance about future
taxes does a great deal. What it does is, if you are a
businessman and you want to invest, the first thing you do, you
learn in business school, is go out and figure out what the
expected rate of return is going to be. You can't do that,
because every day or every week there are new regulations--for
health care, for finance, for labor, also for environment--and
the President is out campaigning for higher tax rates. So you
don't know what you are going to face, and so you sit on a
bundle of cash and wait.
We have never seen so much cash in the hands of banks and
businesses as we do now. So we have to ask ourselves, why is
that? And the answer is, because they are dreadfully uncertain
and lack confidence about what the future is going to be. They
don't know what that future is, and they can't estimate what
the expected rate of return is.
If they invest, they create jobs. Most of the jobs that are
created are created by firms that start up and in the first few
years hire and expand.
Vice Chairman Brady. Thank you, Dr. Meltzer.
Senator DeMint.
Senator DeMint. Thank you, Mr. Chairman.
Dr. Ball, you have referenced an IMF study a number of
times. Is it fair to assume that the study includes many
nations with government workforces that are a larger percent
than the U.S.?
Dr. Ball. Yes.
Senator DeMint. So, then, is a determination of when you
are cutting government spending, that those nations would
likely have a higher unemployment because of that, because that
spending directly affects the government workforce?
Dr. Ball. I don't quite think that follows. The study is
very careful in trying to measure, if we have a spending cut of
a certain percentage of GDP, what are the average effects on
output and unemployment.
Senator DeMint. What we have seen with our deficit spending
over the last few years, generally it is maintaining government
employees at the State levels--teachers, others. But it would
just seem to me, if your hypothesis that deficit spending is
good for the economy and cutting that spending would cause
higher unemployment, that using a study where most of the
nations have a greater percent of government workers as part of
the workforce, it may not necessarily be accurate.
And do you not see the American economy, our free-market,
capitalist system, as somewhat different than most of the other
nations in the world?
Dr. Ball. Well, I mean, this study includes Canada. It
includes a variety of most of the world's advanced countries.
Senator DeMint. Right.
Dr. Ball. And I think--I mean, that is an interesting
thing--that they could follow up, looking at different types of
economies. But I think we are talking here about fairly general
principles of economics that I would think apply to Europe, to
Australia, to the U.S.
Senator DeMint. Well, one of the challenges we have here is
I think there are a lot of folks that want us to be more like
European economies that are centrally planned. That is part of
our different world views that we are dealing with right here.
But let me just--maybe a question to the whole group. And,
Mr. Edwards and Dr. Meltzer, maybe I will go to you first on
this. But we are clearly in uncharted territory right now.
Dr. Meltzer. Yes.
Senator DeMint. We can have different opinions about that.
But the Federal Reserve interventions are unprecedented.
Stimulus spending is at unprecedented levels. The bleak and
unsustainable fiscal outlook that we are dealing with is
unprecedented. The weak and almost nonexistent recovery,
despite the incredible levels of stimulus spending, is
unprecedented.
So how do these factors affect the nearness to the tipping
point? And I know we can't determine exactly where that is. But
I am wondering, where are we going to borrow the money from? We
are projecting a trillion dollars a year, about, that we have
to borrow or print. Where is that going to come from? And
aren't we in such uncharted territories now that we need to do
more than just sound an alarm, or am I just unnecessarily
seeing a bleak situation?
And, Mr. Edwards, I will start with you.
And, Dr. Meltzer, I would like to get your opinion very
quickly, too, if I could.
Mr. Edwards. Yeah, I mean, we don't know where the tipping
point is, where the next financial crisis is. I mean, recent
academic research by Rogoff, Reinhart, and others points out
that different countries are hitting that sort of wall in
different sorts of places.
As I mentioned, I mean, Japan's debt is 200 percent of GDP
and has been for a couple decades. They are in a unique
situation because most of their savings to finance that debt
comes domestically. So we are not in that, you know, lucky
camp. Half of our borrowing now comes from abroad. That is a
real problem, as the CBO points out in their long-range
projections. That means that, in the future, if we keep this
up, we will be producing GDP but a bigger and bigger chunk of
that GDP won't be going to Americans; it will be going to
foreign creditors. So that is why our standard of living will
be suppressed by this buildup of debt.
I must say that, you know, hitting the tipping point
isn't--I mean, that is not the end of the story. Ireland hit
the tipping point, but recent news reports are indicating that
they have taken some very good policy actions, cutting
spending, and they are on the brink of recovery. They are in a
much different situation than Greece, even though both of those
countries had these massive spikes in debt. Ireland has taken
the right policy courses, and they are headed now in the right
direction.
So, again, I don't think the biggest issue facing you is
where the tipping point is. I think it is just, you know,
stopping the bleeding as soon as we can.
Senator DeMint. Dr. Meltzer, quickly--I am almost out of
time--just a comment?
Dr. Meltzer. Let me just say that Ireland did not have a
large debt. It got a large debt because it assumed the debt of
the banking system. It was a private debt. It assumed it as a
public debt. That was a huge mistake that got Ireland into a
problem.
Take the case of Italy, which is a good case for us to
study because it went along for decades with low growth and
high deficits over 100 percent. When it jointed the ECB, it hid
some of its debt, but it was basically over 100 percent,
instead of the 60 percent that was required. Suddenly, that
same situation gave rise to a loss of confidence. That was the
tipping point. Why didn't it occur 2 years, 5 years, 10 years
earlier? I don't think anyone can answer that.
Senator DeMint. Thank you.
I yield back.
Vice Chairman Brady. Thank you, Senator.
Representative Mulvaney of South Carolina is recognized.
Representative Mulvaney. Thank you, Mr. Chairman.
Dr. Ball, I am going to take the unusual step of asking you
some questions. I have learned not to get into a battle of wits
when I am woefully underarmed. It has been a long time since I
have taken economics, so I am going to ask a couple questions
and try not to make too big of a fool of myself.
But let me ask you this question to start off. Do you
believe that there is such a thing as a tipping point in the
size of this debt?
Dr. Ball. Oh, absolutely. And I think probably all three of
us agree there is a tipping point and we don't know where it is
and it would be prudent not to find out. So by no means do I
want to say that we shouldn't be very concerned about long-run
sustainability.
Representative Mulvaney. And that is sort of where I was
hoping we could get. I think one of the things that all three
of you could agree on is that, if we get past that point, it
would be actually much worse than the situation we find
ourselves in today. Is that a fair statement?
Dr. Ball. Probably. I think, again, because the U.S. is
special and this is unprecedented, when it would happen or how
bad it would be--again, it is the kind of thing we don't want
to learn about.
Representative Mulvaney. And that is one of my frustrations
with the classical Keynesians is that they seem to lack, in my
opinion, a long-term outlook. We are always looking quarter to
quarter, we are looking year to year; there is no long term.
And you remember what Dr. Keynes' comment was regarding the
long term that we are all dead.
We have sat in this room this year with a board of experts
regarding entitlements. And I am talking; there were two
Republican witnesses, an independent witness, and a Democrat
witness. And the window of opportunity that that broad group
gave us to fix entitlements was someplace between 2 years for
the most conservative and 5 years for the most progressive or
liberal witnesses that we had.
And one of my concerns is that when I read your analysis,
when I read your testimony, is that we lack any type of mid- to
long-term outlook; that we are simply looking at the next
quarter in an effort to try and boost the GDP.
You go to the end of your testimony, for example, you talk
about why printing money, why expansionary policies might not
have the same type of inflationary outcomes that we have seen
or that many of us, including many of the members of this
board, and I know Mr. Edwards and Dr. Meltzer fear, because you
say that businesses generally do not monitor the Fed's balance
sheet and they do not base their pricing decisions on changes
in the monetary base.
I used to run a business. I can assure you that I didn't
watch the Fed Reserve and I didn't watch expansionary policies.
But what I did watch was my costs. And when my costs went up, I
had to raise my prices. And I can assure you, while I wasn't
watching the Fed, the brokers in food and fuel certainly were.
And as my costs went up because of expansionary policies, I had
no choice but to raise my prices or to go out of business.
You go back to the Weimar Republic. You saw a tremendous
inflation--in fact, hyperinflation--without an overheated
economy. It was driven entirely by the printing of money. There
was high unemployment at that time. There was fairly low
productivity. And what we had was--well, we had middling
productivity but you had tremendous inflation.
One of the things that I fear when I look at your proposals
is that we are underestimating the risk of inflation and
hyperinflation. Take a minute and tell me why I can sleep at
night and I shouldn't be too worried about that.
Dr. Ball. Well, first of all, on the fiscal issues, you
talked about the long run and the short run. I think the quote
about, ``In the long run, we are all dead,'' is something that
people are a little bit embarrassed about now, because the long
run is important.
Again, I think there is a lot of agreement about the long-
run dangers of the debt. It is just, we need to be realistic
about if we are very aggressive right now at cutting the debt,
there will be major costs in the----
Representative Mulvaney. If we believed that we were closer
to the tipping point rather than further, if we believed that
we were closer than you think that we may be--let's say that we
are the 2 years, you are the 5 years--isn't it entirely
rational for us to be taking the steps that we are proposing?
Dr. Ball. Well, I think at some level the right steps are
obvious, and maybe everybody could even agree. It is addressing
the looming--I mean, there is the CBO chart of the debt going
off. That is because of primarily entitlement programs. So, in
a perfect world, Congress would get together and have a
friendly discussion and figure out some nice moderate
compromise on how to fix entitlement programs, and that would
solve the long-term problem without giving a big negative jolt
to the economy today.
I mean, if we address the deficit just by willy-nilly
spending cuts over the next decade, I mean, maybe--I am not
going to say whether that is, overall, good or bad, but there
are going to be--there is going to be higher unemployment.
There are going to be costs. So we should be realistic about
that.
Representative Mulvaney. You mentioned--very quickly, I
have just a few seconds--you mentioned willy-nilly cuts. I
agree with you that simply going in and cutting randomly might
have a different output than coming in and cutting
specifically. The Canada example is one that several of you
have mentioned. And there, if you go back and you look at the
history, it appears as if their cuts focused primarily on
wealth-transfer programs and not on infrastructure.
Would you agree, sir, with the premise that cuts in wealth-
transfer programs might have less of an impact on employment
than cuts to infrastructure spending?
Dr. Ball. I think that is plausible because infrastructure
spending has a substantial effect on employment.
Let me say very briefly on the inflation issue, that is
something where maybe I do differ from others. I think the
fears of inflation really are quite unwarranted, and that is a
bogeyman that doesn't really--again, without a long economic
debate, I think historically in the U.S. inflation pressures
have taken off when the economy is overheated. Unemployment has
been low, so workers push for higher wage increases. Firms are
straining their capacities, so they have more of an incentive
to raise their prices. An overheated economy is obviously the
last thing we need to worry about right now.
Representative Mulvaney. Thank you, Doctor.
Thank you, Mr. Chairman. Sorry to go over my time.
Vice Chairman Brady. No. Thank you.
Mr. Campbell of California is recognized.
Representative Campbell. Thank you, Mr. Chairman.
The subject of this hearing is something I have been
talking about for some years: the real debt limit; and I have
been saying that, although we have had a lot of debates and
disputes here in Congress over the statutory debt limit, that
the statutory debt limit is an arbitrary number, and the real
debt limit is when we reach what we are all today calling as
the tipping point. But the pushback I get on that from some
people--and I would like to ask Dr. Meltzer and Mr. Edwards to
respond to this--is that people say, well, we are really a long
ways from that.
Look at what is happening with Treasury debt today. Look at
the 10-year Treasury dropping--I don't know where it is right
now--right around 2--but dropping at some point below 1.9 or so
forth. The auctions are going out. There is a tremendous
appetite for Treasury debt. The interest rates on Treasury debt
are dropping dramatically. And this is an indication that we
are a long, long ways from that tipping point.
Would either or both of you like to respond to that?
Dr. Meltzer. First, I would say the size of the unfunded
mandate, which is not included in most of the numbers we talk
about--not in the 90 percent, not in the 100 percent--is six to
seven times the size of the deficit, depending upon what
interest rate you use to discount it back for the future. So
that puts us at an enormous amount. It is just as the chart
shows. Mr. Ball and I agree. It is the Medicare and Medicaid
expenditure that is going to cause us the problems we have.
Social Security is a minor but important part of the problem,
but it pales in significance compared to Medicare and Medicaid.
So there are lots of things we can do, and there are a lot
of things we can do to Medicare and Medicaid that don't require
taking away promised benefits to people but changing them. For
example--and just one of many examples--we have to ask: Why do
we spend about 50 percent of the Medicare money on people who
are within 6 months of dying? Now, they don't all die. So, for
some, there is a benefit. But there is no copay attached to
that. If we attached a copay and graduate it according to
income, we would reduce a lot of----
Representative Campbell. Dr. Meltzer, just because of the
time, how do you respond to those people that say, in spite of
all this, that we have considerably more debt that we can run
up and that the evidence of that is the appetite for and the
low interest rate on Treasury bills?
Dr. Meltzer. The reason we have the low interest rate is
because the Fed enforces it. If you want to look at where the
pressure is coming from, look at the fact that the dollar has
depreciated by about 15 percent against a weak currency like
the Euro and by an even larger percent against a weak currency
like the Japanese Yen, that the most recent inflation number
was 3.8 percent--well above the Fed's target.
So I don't buy the argument that in a weak economy you
don't get inflation. You gave the example of Germany. Spain at
the moment has 20 percent unemployment. Prices are rising.
Britain has a high unemployment rate. Prices are rising. So
there are other sources other than the labor market to give you
inflation. And we are going to get them.
Representative Campbell. Mr. Edwards.
Mr. Edwards. There are these gigantic negative risks out
there that something big and bad is going to happen to the
American economy. We don't know what it is. If you go back and
look at the January, 2008, CBO projection, they didn't project
a recession. They said, well, maybe a recession would happen.
But they actually projected growth would be strengthening in
coming years. So we are going to be surprised by the next big
recession or negative factor.
If you look at CBO projections, I mean, there are no
recessions in their 10-year outlook. But what if we have a
gigantic recession a few years from now, another major
recession? Tax revenues would plunge again, unemployment comp
costs would soar, a lot of policymakers would want to do
another giant stimulus, and we would be in this spiral downward
of debt and poor economic growth.
So we have got to start planning now. The risk factors are
all on the negative side. European countries have this horrible
demographic problem--worse than ours. Their debt loads are
going up. So the higher their debt loads become and the higher
ours become, the more risk of an international sort of a
contagion, the more we are all at sort of a tipping point. If
Europe can go into another deep recession, it would cause a
deep recession here. The risks are all on the ugly side.
Representative Campbell. In my last 15 seconds, do any of
you want to comment on the thing the Fed is discussing to
change the maturities of the debt that they hold?
Dr. Meltzer. It won't do much. They tried it back in the
1960s. They had a big experiment. It didn't work. That is,
their own research at the Fed said it didn't work. Why? Well,
think about it. If you suppress long-term rates and raise
short-term rates, what do you think the market people are going
to do? They are going to go the other way.
Representative Campbell. All right. My time is expired.
Vice Chairman Brady. Thank you.
The chair recognizes Dr. Burgess of Texas.
Representative Burgess. Dr. Meltzer, you referenced just a
moment ago about the costs of Medicare for patients in the last
months, even weeks, of life. I will just tell you, as somebody
who practiced medicine for a number of years, the principal
problem we have there is the lack of transparency on the part
of the patient. They don't tell us when that last 2 weeks
begins. So it makes it very, very difficult for us to balance
our decisions.
Dr. Meltzer. Of course.
Representative Burgess. But along that line, you talk about
the cost drivers contained within Medicare and Medicaid and you
talked about perhaps changing things so that they don't take
away future benefits. I will submit within the health care
realm there is probably $1.3 trillion in immediate savings that
will not take away future benefits, and that would be to delay
the implementation of the Affordable Care Act, which nobody
seems to seriously consider when they have deficit commissions
or talk to the President. Is that something that this Congress
should take under serious consideration?
Dr. Meltzer. Yes.
Representative Burgess. Thank you.
We also talked--and this is for any one of you--we talked a
great deal about cash on the sidelines. I have talked to a
number of my community bankers, not just in the August recess
but going back this past year and a little bit longer. The
community bankers tell me that they are hampered by the fact
that they must keep their loan-to-deposit ratio under 80
percent or they will invite a visit from some type of bank
examiner, and that visit may not be pleasant. So they take
pains to not go that last--to not touch that last 20 percent as
a consequence. They are not making money on that 20 percent of
deposits. The community is deprived of the loans that those 20
percent of deposits could create.
Do any one of you have a sense that that is a bigger
problem than what has been talked about before?
Dr. Ball. If I may comment, I think that is a problem. I
think probably depressed lending by community banks is one
factor holding back the recovery. And perhaps regulators could
change their attitude a little bit or think of creative ways to
encourage lending and perhaps help recapitalize community
banks.
Representative Burgess. But we have kind of gone the other
way in the past 18 to 24 months; and rather than making the
regulations, perhaps clarifying them even, we have made them
more obscure, as has been previously mentioned. We frighten
people with what is the future regulatory environment that they
are going to encounter.
Dr. Meltzer, is that one of the reasons this cash is
staying on the sidelines?
Dr. Meltzer. That is one of the reasons. That is generally
regulation. As Speaker Boehner said so well in his speech the
other day, you can move your plant to China, but you can't move
it to South Carolina. That sounds funny, but at the same time
it really tells us a serious thing about what regulation does
to the attitudes of businessmen.
Representative Burgess. And we are talking right now and
the President is talking about raising taxes to create jobs,
and yet this is the same White House that just this weekend
said that Lockheed in Fort Worth can't sell F-16s to Taiwan.
Their National Labor Relations Board said you can't build
Boeing aircraft in South Carolina, and American Airlines
biggest jet purchase in the history of the country, probably,
is buying non-Boeing products for perhaps the first time in
their company's history.
American Airlines is buying non-American-produced jets.
Eight to 18 power plants are going to close in Texas on
January 1 because the Cross-State Air Pollution Rule is going
to be a significant detriment on jobs.
The Keystone Pipeline, argue the environmental effects one
way or the other, but the White House simply will not make a
decision, whether they say yes or no.
Drilling in the Arctic for Shell Oil, they just will not
make a decision.
The problem, as I see it, is not that taxes are not high
enough. It is that the White House is so risk averse, it is
afraid to act.
Do any of you have an opinion about that?
Dr. Meltzer. I agree with that completely. You don't know
what the future is going to be. Cash is your friend.
Mr. Edwards. Just a general sort of a comment. There has
been so much focus in the last few years by policymakers in
Washington on macroeconomics--a misguided focus in certain
ways, in my view. Microeconomics is extremely important. If you
go back, for example, and look at what Margaret Thatcher did
after a decade of stagnation in the 1970s in Britain, sure she
got the macroeconomics in order, but she did a heck of a lot of
on the microeconomic side. Tax reform, deregulation,
privatization, all those things, it is hard to quantify the
impact on the economy. But there is no doubt that fast-growth
economies, they are getting both the macro and microeconomics
right.
Dr. Meltzer. I would like to second that. I worked with
Mrs. Thatcher some of the time. She was a real leader. She was
willing to make tough decisions.
Representative Burgess. Thank you, Mr. Chairman.
Vice Chairman Brady. Thank you.
We are going to undergo a second round of questioning by
Mr. Cummings and Senator DeMint.
Mr. Cummings is recognized.
Representative Cummings. Dr. Ball, to what extent are our
current deficits being driven by slow economic growth and what
impact would more robust economic growth have on our ability to
reduce the deficits and rein in the debt? And the proposals--
the most recent jobs proposals that were presented by the
President, I just wanted to know what your opinion of those
might be and do you feel that they would be helpful, as many
economists have projected?
Dr. Ball. I think there is absolutely no question that the
main driving force behind the big run-up in the budget deficit
is the economic slump. Somebody else referred to lower tax
revenues, higher unemployment insurance. It is a very strong
economic regularity that deficits go up in recession. So we
have had a big recession. And that is the main thing.
The stimulus program added to the debt, but it was
secondary just compared to the recession. And, absolutely, if
we can find a way to restore robust growth, that is the best
possible deficit reduction plan. Anything which retards growth
is going to be somewhat self-defeating as far as the fiscal
situation because of the effects of growth on the deficit.
As far as the President's jobs plan, I haven't studied it
in detail. It seems like a step in the right direction.
It stills seems, frankly, we face a huge problem. Actually,
whether it is the President's jobs plan or various deregulation
or things the Fed can do, it is not clear that any of the
measures we have are really sufficient, that we may have to
either really try something more radical or accept that we are
going to live with high unemployment for quite a while.
Dr. Meltzer. Mr. Cummings, that jobs plan costs $200,000
per job. My wife, who is not an economist, listened to that and
said, why don't we pick the same people, give them $150,000,
and we will be ahead of the game? We are not going to get out
of this problem by spending $200,000 per job.
Representative Cummings. So, Dr. Meltzer, you are saying
that you can't--one of the things that has always bothered me
about all of this is you look at something like infrastructure,
and in Maryland they say we have got a sinkhole developing
every 8 minutes.
Let me finish, Dr. Meltzer. I see you shaking your head.
Dr. Meltzer. I agree with that.
Representative Cummings. Every 8 minutes. We have got
bridges falling apart. I told some people the other day, you
can erode from the inside. You can die from the inside. If you
are not educating your people, if you are not innovative, you
can't be competitive. So at what point--I mean, seems to me,
you have got to spend carefully to get the economy going and
get people moving--carefully--but at the same time you can't
die in the process. Because by the time you get out of the
mess, you don't have a country.
Dr. Meltzer. I agree, Mr. Cummings.
Representative Cummings. You agree with me?
Dr. Meltzer. I agree the infrastructure in the United
States is bad. I live in Pittsburgh. I will match you bridge
for bridge, and I will have a whole bunch left over. So,
absolutely. But if you think that you are going to take
carpenters and bricklayers and convert them into road builders
and bridge builders overnight, you are kidding yourself.
Building a bridge is a big job, and it requires people who are
trained in steel.
The President says, well, just let's take some of the
unemployed construction workers and make them road builders.
Have you watched them build roads? They use heavy equipment.
You have to learn how to drive that. That is not going to be a
solution.
I agree. We have a long-term problem of infrastructure, and
we are to do what we can about infrastructure. That is a
constructive thing. We have waited way too long to do something
about it.
Education. We really have tried with education. It is
terribly important. The gap in incomes between the poor and the
rich is driven mainly by the fact that technology has changed.
I was a corporate officer or director. If you didn't have
an education, you couldn't read the computer that was beside
your work station, you swept the floor. That is a loss of
people. We need to do something about that. I wish I thought I
knew what we needed to do.
Representative Cummings. Thank you very much.
Vice Chairman Brady. Thank you.
Senator DeMint is recognized.
Senator DeMint. Thank you, Mr. Chairman.
I want to thank Congressman Cummings and Dr. Ball for kind
of presenting the alternative view today. Obviously, we have a
big difference of opinion in Washington about what we need to
do to fix the problem.
I, frankly, don't think I am looking at this through a
political prism. I am thinking of it as a guy who was in
business for many years. I consulted with a number of other
businesses. So my political perspective is really not a
political perspective. And what I am looking at today, by any
measure from a business perspective, our Nation is bankrupt, if
you look at the balance sheet. We have got a negative cash flow
projected continuously, indefinitely. Most of our operating
capital is borrowed money. Every new program we suggest has to
be borrowed or printed.
So our fate is in the hands of our creditors. That is a
worrisome situation. I don't know how we can get around that.
And the solution, if you use a business parallel, the 3
percent of Americans who make over $200,000 also happen to
create most of our jobs and give the most to charity, provide
60 percent of all investment capital. They happen to be the
ones making things happen. Taking more money from them and
giving it to the people who are creating the debt does not seem
to be making a lot of common sense.
So just like a business whose revenue is down and they
decide the best way to get out of that is to raise their
prices, that is what we are talking about doing here. Our
business is down. Our revenue is down. So we want to raise the
prices on who are effectively our customers, those who are
creating the revenue for us. And that is a difficult thing to
swallow when we know in economy--it may not be true in IMF
economies, but we have got a economy where 3 percent of
Americans are already paying over half of the taxes. They are
the ones creating the jobs, providing the investment capital.
Frankly, that is not going to solve our problem.
If you look at the data for the last 10 years, the increase
in our deficit is mostly attributable to an increase in
spending, and that includes a lot of discretionary spending.
Social Security has not contributed to our debt at all. In
fact, if we hadn't borrowed $3.6 trillion from Social Security,
we would be a whole lot more in debt than we are today.
So this is not all on the entitlements. This is on a belief
of government that we need to direct the economy. And I think
the difference of opinion here is that the government is the
primary stimulator of the economy versus those of us who think
the reason America was so exceptional and prosperous was that
we were a bottom-up economy with millions of people starting
businesses, innovating, being entrepreneurs. Those are the
people we seem to want to attack right now. Of those who have
income over $200,000, 40 percent of their income is small
business income.
So I understand the need to balance revenue as well as
spending cuts, but we can get new revenue by making the economy
grow. Frankly, if you look at 20-year data, you can raise the
taxes as much as you want, but the revenue is going to be about
20 percent of our GDP--excuse me--18 to 19 percent of our GDP
over time.
So I appreciate all of our panelists helping us to talk
through this. To me, this is a situation where, like all of you
have said, let's not wait to find out. Because all this is
going to take is China to say they are not going to lend us
more money, to dump our debt at 80 cents on the dollar. And the
faith that keeps us up--and that is what we do have to admit,
that the only thing keeping our dollar up, keeping what economy
we have going is faith and the fact that other economies are
worse off than we are right now.
But thank you for helping us talk through this. Mr.
Chairman, to you and your committee staff, I appreciate all the
work you have done. I appreciate all the folks who have
answered questions, and I hope we will follow up with some
decisive action that will solve our problem.
Vice Chairman Brady. First, let me thank Senator DeMint for
leading this hearing today and the members of the Joint
Economic Committee, both parties, for engaging. I so much
appreciate the insight and thoughts provided by our panelists
as well.
To borrow from the President's current speech, it is clear
the real debt limit is upon us now. We have to act credibly to
reduce that debt--and now--and we need to get Washington out of
the way of our recovery now.
With that, the meeting is adjourned.
[Whereupon, at 11:21 a.m., the committee was adjourned.]
SUBMISSIONS FOR THE RECORD
Prepared Statement of Representative Kevin Brady, Vice Chairman, Joint
Economic Committee
When the Joint Economic Committee must hold a hearing on what the
real debt limit is, the American people know instinctively that their
federal government is borrowing too much. One does not really want to
contemplate the grave consequences if creditors were to lose faith in
the federal government to repay its debts.
The United States supplies the world's primary reserve currency;
has the world's largest economy; and is source of much of the world's
technological progress and economic development. The federal government
should never violate its real debt limit because the consequences of
exceeding it would be calamitous not just for the United States but
indeed the entire world.
Nevertheless, the JEC must hold this hearing because the question
now is asked: What is the real debt limit? Amazingly there are some
that do not believe the U.S. has a serious debt problem. Given the
anemic recovery, these individuals argue that President Obama's deficit
spending splurge should continue. ``Don't worry because interest rates
on Treasuries remain low, and the federal government can print more
money to pay all its debts,'' they say.
I hope that today's hearing sheds light on the fallacy of this
mindset and puts an end to it.
Keynesian theory tells us to ignore the level of federal debt and
continue deficit spending until full employment has been achieved.
Well, we simply cannot ignore the debt anymore.
According to recent economic studies, when gross government debt
relative to size of the economy exceeds a certain threshold, the
economic growth and job creation slow dramatically. Economists Carmen
Reinhart and Kenneth Rogoff put the threshold at 90%, while another
study by economists at the Bank of International Settlements put it at
85%. The page in the Keynesian playbook on what policymakers should do
when gross government debt exceeds this threshold and high unemployment
persists is--blank.
Gross federal debt already exceeds 98% of GDP and is on course to
exceed 100% next year according to the Congressional Budget Office
(CBO). Now that we are staring at that empty page in the Keynesian
playbook, we have to forge a new path.
The dynamics of rising federal debt relative to our economy are
dangerous. The federal government must stay clear of the undertow of
deteriorating economic performance, rising interest rates, and higher
tax rates.
To begin, we must discard fiscal policies that have not been
working. Economists John Taylor and Michael Boskin have detailed how
the Obama ``stimulus'' and other federal spending were wasted on
transfers that produced no lasting growth. We cannot afford another
round of ``stimulus'' disguised as a ``jobs'' bill.
Growth is what we need. In the following chart, the top line shows
the gross debt-to-GDP ratios for the next ten years, as implied by
CBO's projections since the Budget Control Act was adopted. The average
annual growth rate during the forecast period is 4.2% for gross debt
and 4.6% for nominal gross domestic product (GDP)--just slightly
higher. This is why the ratio of the two ends close to where it starts.
The blue line shows the ratio if the debt grew only 2% while nominal
GDP grew 6% per year.
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The U.S. economy must grow significantly faster than federal debt
to move the ratio down from the dangerous levels around 90%. In the
CBO's outlook for the Administration's budget, that fails to happen;
the spread in trajectories of debt and economic growth is too small.
Viewed this way, it is obvious that the country's economic policies
must change, and not only with regard to federal spending and
borrowing. Myriad regulations that hamstring economic activity and
discourage private investment must be reversed, and the anti-employer
attitude must go.
We know that entrepreneurs, investors, and consumers on Main Street
fear the consequences of the rising federal debt. The real debt limit
is upon us. We must act credibly to contain federal debt and release
the private economy so that it can grow as it has in the past and how
it must grow again.
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Prepared Statement of Dr. Allan H. Meltzer
Vice Chairman Brady, Senator DeMint, Members of the Committee.
It is a pleasure to appear again before the Joint Economic
Committee. My association with this committee goes back to the days of
Senator Paul Douglas. It was Sen. Douglas who pushed and prodded the
Federal Reserve to stop holding interest rates fixed and permit
monetary policy to do much more to prevent inflation. His views
eventually prevailed. That should remind the members of their
responsibility.
Today, I will answer the questions that this hearing topic seeks to
address. The question of ``what is the real debt limit'' includes some
good questions that show rising concern for the consequences of recent
Federal Reserve actions. I will introduce my answers with my
explanations of why Federal Reserve policy is misguided and mistaken,
inflationary and inappropriate. There are several reasons. I will give
three.
First, in writing the three volumes of ``A History of the Federal
Reserve,'' I read more minutes and transcripts than any person can
endure. With very rare exceptions, notably in the years when Paul
Volcker led the disinflation policy, one looks in vain for a statement
of the medium-term consequences of the actions taken at the meeting.
True, the staff and others provide forecasts of the future, but the
FOMC never tries to reach agreement on the consequences of its actions
for the public. It publishes forecasts but there is no clear relation
between forecasts and actions.
Second, concerns at FOMC meetings are mainly about the near-term.
The Federal Reserve has little influence over what will happen in the
near-term but much greater influence on the medium-term. The present is
characteristic. The Fed Chairman and some of the members seem
determined to ``do something'' more about the excessive waste and harm
of high unemployment. They neglect the fact that there is no shortage
of money and liquidity and that they have pushed and prodded market
interest rates to the lowest levels ever achieved. THE UNITED STATES
DOES NOT HAVE A PROBLEM OF TOO LITTLE LIQUIDITY. THERE IS NOT MUCH THAT
THE FEDERAL RESERVE CAN DO BY ADDING RESERVES OR LOWERING INTEREST
RATES. Doesn't the Chairman and several members understand that there
are limits to what the Federal Reserve can do? Banks hold more than
$1.5 trillion of idle reserves. Money growth (M2) for the past 6 months
is rising at almost 15 percent annual rate. (See chart.) Prices are
rising and the U.S. dollar continues to sink. THE MOST USEFUL ACTION
WOULD BE ANNOUNCEMENT OF AN ENFORCEABLE INFLATION TARGET TO GIVE
CONFIDENCE THAT WE WILL NOT INFLATE.
Third, in 1977 Congress gave the Federal Reserve a dual mandate,
interpreted as low unemployment and low inflation. It pursues those
goals in an inefficient way by pursuing unemployment until inflation
rises, shifting to inflation control until unemployment rises, and back
and forth. That way, it achieves neither. The Great Inflation of the
1970s is an example. Both unemployment and inflation rose. The current
Fed repeats that pattern. In contrast, policy from 1985 to 2003 more or
less followed a rule that included both goals. That gave the public one
of the very few years of low inflation and stable growth in the Fed's
100 year history. In Article 1, Section 8, our constitution gives
Congress ultimate control of money. It should legislate an enforceable
inflation target. I will amplify ``enforceable'' if you wish.
Now to the more specific questions of the real debt limit.
First, given the fiscal policy of the industrialized nations, will
government debt crowd out private investment spending? My answer is
yes. Today's deficits and debt raise concerns about future tax rates.
The prospect of higher future tax rates raises the rate of return that
business investors want to earn on new investment. And uncertainty
about future tax rates and the persistent increase in regulation of
health, labor, energy, and finance has deterred investment and slowed
recovery. Faced with heightened, current uncertainty, many investors
hold cash and wait. Cash is their friend. Government budget and
regulatory policies deter, crowd out, investment.
Second, the original Federal Reserve Act prohibited loans to the
Treasury. Early in its history the Federal Reserve circumvented the
prohibition by buying Treasury bonds from the market after the Treasury
sells them. This monetizes debt. With the exception of wartime, the
Federal Reserve bought mainly very short-term Treasury bills. In the
1950s, it ran a ``bills only'' policy. Recently it has done what no
central bank should do: It has implemented the government's fiscal
policy by buying long-term Treasury bonds and $1 trillion worth of
mortgage-backed securities. Ask them how they plan to sell mortgages in
this mortgage market. The screams from homebuilders would be heard all
across the country. A straightforward way of saying the same thing is
that THE FEDERAL RESERVE DOES NOT HAVE A CREDIBLE PROGRAM FOR SHRINKING
ITS BALANCE SHEET.
If Treasury rates rise, the Federal Reserve portfolio will lose
value. Until Dodd-Frank, 90 percent of the Fed's earnings became
Treasury receipts, so the Treasury and the taxpayers bear the cost of
the recent change. Dodd-Frank authorizes the new consumer agency to
sequester Federal Reserve earnings without approval by the Congress or
the Fed. I have been told that this off-budget finance is not
unconstitutional. I continue to believe that the Congress should
prohibit ALL off-budget finance. The constitutional provision that
makes Congress responsible for spending should be strengthened.
The question regarding the implications of our enormous debt has
several parts. Some ask for more precise answers than anyone can give
correctly.
The ``tipping point'': Some authors say a ratio of 90 to 100 for
government debt to gross domestic product (GDP) is a ceiling. Beyond
the ceiling, interest rates rise suddenly because bond investors fear
inflation, default, or sharply rising interest rates and losses in the
value of bond holdings. We are there. Public debt is $14.7 trillion,
and second quarter nominal GDP is $15 trillion. If we add, as we
should, to the current U.S. government debt, the promises to pay
obligations of Fannie Mae, Freddie Mac, the Federal financing bank and
the unfunded liability for Medicare, Medicaid, and Social Security, the
debt of the United States government passed the 90 percent ratio years
ago. Currently, unfunded debt in the medical programs reaches $70 to
$100 trillion, as much as 6 or 7 times the reported debt, depending on
the rates used to discount future promises. The ``full faith and credit
of the United States'' is stretched far above the ability to pay. Yet
interest rates on government bonds are lower than they have ever been.
There is no sign in current interest rates of the looming debt problem.
Exchange rates tell a different story.
Why wait for a ``tipping point'' and a crisis? We have ample
warning that we are on an unsustainable path. We don't know when a
crisis will occur, and we should not wait to learn whether it does.
PRUDENT POLICY ANTICIPATES CALAMATIES BEFORE THEY OCCUR. RESPONSIBLE
POLICY MAKERS DON'T WAIT FOR CRISES.
Japan's outstanding public debt is at least double its GDP.
Government debt for Italy and Belgium has long been above 100 percent
of GDP. I do not know what unfunded liabilities may add to these sums.
They suggest that we will not find a precise number like 90 percent of
GDP to warn us of impending interest rate increases. But we also know
from the recent experience of Greece and Italy that sudden changes in
market perceptions occur. What was acceptable suddenly becomes
unacceptable. This is a warning that prudent folks will heed.
Perhaps we should see a warning in the fact that our debt and
deficits are unsustainable. Every knowledgeable observer recognizes
that. Why wait for a market crisis to tell us what we already know?
At a time of considerable uncertainty about the future of
currencies and economies, the large, open market for U.S. debt is a
refuge for frightened investors. The Federal Reserve does not let
interest rates increase, so holders think they are protected from
losses caused by rising interest rates. Some hope for additional gains
if the Fed lowers rates by making additional large-scale purchases. The
result is that for the present holders are willing to accept negative
real returns on their bonds. Negative real returns subtract the current
inflation rate from the current market interest rate.
Japan's relatively large debt is almost entirely owned by Japanese
citizens. Unlike our current citizens, Japanese save and put much of
their saving into Japanese institutions that buy government debt. The
nominal interest rate on long-term Japanese debt has remained between 1
and 2 percent for many years. Investors expect that pattern to
continue, so there is no sign of an impending debt crisis. Japanese
experience should not make us sanguine. We depend on the rest of the
world to finance at least half our annual budget deficit. That's a risk
for us but not for Japan.
Italy is instructive. The debt-to-GDP ratio remained above 100
percent for years. Italian savers bought a large part of the debt. As
concerns about the future of the euro rose, Italian debt suddenly and
unexpectedly rose in yield and fell in price. The European Central Bank
made large purchases to reassure investors that there was a residual
buyer. Uncertainty about what will happen in the future, not the
distant future, remains.
German and French banks hold large amounts of Italian debt. They
would like a government bailout, so they pressure governments.
Meanwhile, they sell as much of the Greek, Italian, and Spanish debt as
they can.
The sudden crisis affecting Greece and Italy teaches two things of
value to us. One is market perceptions and actions can change quickly.
The other is that prudent policy does not wait for the crisis. It acts
before when many more options are available. It would be better to
adopt Congressman Ryan's budget plan that leaves current and near-term
health care beneficiaries unharmed than to wait for a crisis that
forces much more immediate, drastic action and harms current
recipients.
If rates spike up, without warning, we will be forced to make
sharp, sudden changes in spending and tax rates. The alternatives are
default and inflation. Default would harm the credit of the United
States for years, even decades. It should be unthinkable.
Many now propose to ease the debt burden by raising the inflation
rate to 5 or 6 percent. That would reduce the burden of long-term debt
and mortgages, but it would raise interest rates for new debt issues
and refunding. The average maturity of outstanding debt is between 3
and 4 years, so we would face higher interest rate expense very soon. I
would like the proponents of a higher inflation target to tell us how
they propose to bring the inflation rate down in the future. It is
unlikely that we can reduce inflation without causing a new recession.
People invest expecting inflation to continue. Farmers borrow to buy
land. Home builders suffer a collapse when disinflation raises interest
rates. Moreover inflation will not put much of a dent in the enormous
unfunded liability for health care. And it cheats the principal holders
of U.S. debt, especially China and Japan, with unforeseen consequences.
Recent unprecedented actions by the Federal Reserve solicit
questions about limits to Federal Reserve monetary expansion. There are
no legal restrictions. The only limit I know comes from the public. At
some inflation rate, the public will demand less inflation. In 1979,
inflation reached double digits. The public declared inflation to be
the major economic problem. President Carter responded by appointing a
known anti-inflationist, Paul Volcker. In his interview, Volcker told
the president that he would reduce inflation. President Carter
responded that was what he wanted. He had not taken effective action
before, but he faced an election in which the public wanted lower
inflation.
Increasing inflation until the public responds is not the right
answer. One part of the right answer is to reach a long-term budget
agreement that brings government spending below sustained GDP growth.
That will be difficult but there is much waste in health care and other
spending. I will expand a bit if you wish. The other part of the right
answer is to rein in the unrestricted power of the Federal Reserve by
imposing an inflation target.
And finally, what might be the consequences of adopting stabilizing
policies? Ten years from now, we will export more and import relatively
less. We will grow family incomes at about our long-term trend.
Consumption will grow more slowly than in recent years because we must
export more and import less to service the nearly $ 5 trillion of debt
owed to foreigners. Foreigners will have to find a substitute for
export-led growth because we can no longer be the importer of last
resort. Of major importance for the future is the smaller role we will
play in maintaining world peace. The United States cannot be the
world's policeman. But political stability is vital. That's a big,
separate set of issues that take us far afield.
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Prepared Statement of Dr. Laurence Ball
Chairman Casey, Vice Chairman Brady, and members of the Committee,
I am grateful for the opportunity to discuss the challenges to the
U.S. economy posed by the combination of rising government debt and
high unemployment. I will also comment briefly on current Federal
Reserve policy, which your committee is also considering.
THE COSTS OF FISCAL CONSOLIDATION
Indisputably, Congress must address the problem of rising debt to
prevent a fiscal crisis that could gravely damage the economy. How to
solve this problem is a complex issue. We need policies that will keep
debt on a sustainable path while providing essential government
services and minimizing the economic distortions caused by taxation. I
will not analyze all these issues or presume to say what fiscal
policies Congress should adopt. Instead, I will focus on a more narrow
question: What are the short- and medium-run impacts of fiscal
consolidation--of cuts in government spending or tax increases--on
economic growth and unemployment? Congress must understand these
effects to choose the best response to rising government debt.
Opinions about the effects of fiscal policy vary widely. Most
economics textbooks teach that a fiscal consolidation slows the economy
in the short run. Higher taxes or lower government spending reduce the
demand for goods and services, reducing growth and increasing
unemployment. Yet some economists and policymakers disagree with this
view, suggesting that fiscal consolidations are expansionary. One view
is that lower budget deficits strengthen confidence in the economy,
leading to higher consumption spending and more investment by firms.
Both sides of this debate present logical and plausible arguments.
If we want to know who is right, we have to look at the evidence.
Fortunately, history provides numerous examples of fiscal
consolidations that we can study. And in my reading of the evidence,
the verdict of history is clear: fiscal consolidations slow the
economy, with adverse effects that last for five years or more. That
is, if Congress cuts spending or raises taxes today, the consequences
will include slower economic growth and higher unemployment than we
would otherwise expect until at least 2016.
Numerous studies (admittedly, not all studies) support the
conclusion that fiscal consolidations are contractionary. I will focus,
however, on several studies performed over the past two years in the
Research Department of the International Monetary Fund. In my view,
this work provides the best available evidence on the effects of fiscal
consolidation, because of the wealth of data that it examines and its
straightforward and compelling methodology. In addition, the expertise
of the IMF's staff and its history of promoting responsible fiscal
policy lend credibility to its analysis. (I should note that I am a
part-time visiting scholar at the IMF, but not a lead researcher in its
work on fiscal policy.)
The basis of the IMF research is a painstaking review of history in
15 countries over the period from 1980 through 2009. Based on records
of fiscal policy decisions, the researchers have identified a total of
173 years in which governments adopted policies to reduce budget
deficits--either spending cuts, tax increases, or a combination of the
two.
Having identified fiscal consolidations, the IMF researchers
measure the effects with very simple statistical techniques. They ask
whether economic growth and unemployment were higher or lower after
consolidations than one would expect based on their normal behavior.
The central conclusions concern the average effects of consolidation
across the 173 episodes. It is essential to average over many episodes
to eliminate the influences of factors besides fiscal policy that may
affect the economy in any one case.
How does a fiscal consolidation affect growth and unemployment? The
IMF research finds that a consolidation that reduces the budget deficit
by one percent of GDP reduces future GDP by 0.6 percent after two
years. The effect then diminishes, but GDP is still 0.4 percent lower
after five years. The consolidation raises the unemployment rate by 0.4
percentage points after two years and 0.2 points after five years.
The research also finds that the effects of fiscal consolidations
vary with economic circumstances. In particular, the average effects I
have just cited are likely to understate the contractionary effects of
consolidation in today's U.S. economy. In a typical episode in the IMF
data set, a country's central bank responds to fiscal consolidation by
reducing short-term interest rates, and this monetary easing dampens
the effects of the consolidation. In the United States today, the
Federal Reserve cannot reduce interest rates because short-term rates
are already near their lower bound of zero. According to the IMF study,
the effects of fiscal consolidation are about twice their normal sizes
if interest rates are near the zero bound. This doubling means that a
consolidation of one percent of GDP reduces GDP by 1.2 percent after
two years and raises unemployment by 0.8 percentage points.
What do these numbers mean? To understand them better, let's focus
on unemployment effects and consider one hypothetical fiscal
consolidation. The Congressional Budget Office forecasts that the
budget deficit will be about 3% of GDP in 2014 and stay near that level
through 2020. Suppose that Congress chooses to eliminate this 3%
deficit: it cuts spending and/or raises taxes by a total of 3% of GDP,
so the deficit settles near zero. What will happen to unemployment?
As I have discussed, the IMF research suggests that a consolidation
of one percent of GDP under current circumstances raises unemployment
by 0.8 percentage points after two years. This implies that the 3%
consolidation in our example would raise unemployment by 2.4 percentage
points. With a U.S. labor force of 150 million people, an additional
3.6 million Americans and their families would suffer the consequences
of a lost job.
Let me mention another important finding of the IMF study. Recent
debates about U.S. fiscal policy have focused on the choice between
deficit reduction through cuts in government spending and through tax
increases. This choice matters greatly to the beneficiaries of
government spending and to taxpayers. In one way, however, the choice
is not important. The IMF researchers perform separate analyses of
spending cuts and tax increases and find that the adverse effects on
economic growth and unemployment are similar (at least in the case when
interest rates are near zero).
Is there any way to control government debt without harming the
economy in the short run? The IMF's findings suggest a type of policy
that could achieve this goal: a fiscal consolidation in which spending
cuts and tax increases are backloaded in time. Under such a policy, the
government commits to lower deficits in the future without sharply
cutting the current deficit. An example is a cost-saving change in
entitlement programs, such as an increase in the retirement age, that
is phased in over time. Such a policy could put government debt on a
sustainable path without raising unemployment sharply. By the time
major spending cuts occur, we can hope the economy has recovered from
its current slump and unemployment is lower. Spending cuts would be
less painful at that point than they would be now. One reason is that
interest rates would be above zero, allowing a monetary easing.
WILL INFLATION RISE?
I have mentioned the fact that the Federal Reserve is holding
short-term interest rates near zero--a highly unusual policy by
historical standards. The Fed has also purchased large quantities of
Treasury bonds and mortgage-backed securities, causing the monetary
base to triple. Further asset purchases appear to be under
consideration. Some economists and policymakers have expressed concern
that these policies will cause inflation to rise to undesirable levels.
Let me comment on this issue briefly, explaining why I believe that
fears of inflation are unwarranted.
At first blush, the Fed's near-zero interest rate target and its
expansion of the monetary base are highly expansionary policies. In
normal times, such policies would indeed cause inflation to rise. But
these are not normal times.
We need to remember why expansionary monetary policy normally
causes inflation. Inflation occurs when businesses around the country
raise their prices. These businesses generally do not monitor the Fed's
balance sheet, and they do not base their pricing decisions on changes
in the monetary base. Instead, monetary policy affects inflation
indirectly, through its effects on aggregate spending. If policy is too
expansionary, the economy overheats. Firms see their sales rise and
their productive capacity is strained, and workers find that jobs are
plentiful. Under these conditions, firms are likely to raise prices
rapidly and workers push for large wage increases.
Given this mechanism, inflation is a danger only if the economy is
overheated--regardless of what the Fed is doing to its balance sheet.
In today's environment, with unemployment above 9% and likely to stay
high for years, an overheated economy is the last thing we should worry
about. Some day the economy will recover and the Fed will need to exit
from its current expansionary policy. But today's challenge is the
terrible problem of 9% unemployment. Rather than scale back its
policies, the Fed should redouble its efforts to stimulate the economy
and push unemployment down.